Capital Structure Finacial Concept Brooks

Chapter 16
Capital
Structure
Learning Objectives
1. Explain why borrowing rates are different based on ability
to repay loans.
2. Demonstrate the benefits of borrowing.
3. Calculate the break-even EBIT for different capital
structures.
4. Explain the appropriate borrowing strategy under the
pecking order hypothesis.
5. Develop the arguments for the optimal capital structure
in a world of no taxes and no bankruptcy and in a world
of corporate taxes with no bankruptcy costs.
6. Understand the static theory of capital structure and the
trade-off between the benefits of the tax shield and the
cost of bankruptcy.
16-2
2013 Pearson Education, Inc. All rights reserved.
16.1 Capital Markets: A Quick Review

Companies raise funds for growth in debt and
equity markets.
Investors have different risk preferences and
companies have varying risk profiles.
The cost that a firm pays for its debt or the rate of
return that investors demand to purchase equity in
a firm depends largely on the firms debt rating and
its beta or systematic risk measure.
Riskier firms end up paying higher yields on debt
securities and are expected to pay a higher rate of
return on their equity, thereby raising their average
cost of capital.
16-3
16.1 Capital Markets: A Quick Review (continued)
Example 1: Effect of risk on borrowing rates.

Mike and Agnes are two venture capitalists with fairly different
risk profiles.
On average, both investors are willing to commit $1,000,000 per
project to cutting-edge ideas and products that they think will fly.
However, Mike is more conservative in that he tends to select low
risk projects that he thinks have at least a 50% chance of being
successful,
While Agnes selects high risk projects that have at least 20%
chance of doing well. Their success rates have tended to be right
in line with their expectations.
Based on their track records, what is the minimum rate that each
investor is willing to lend $1,000,000 at?
16-4
16.1 Capital Markets: A Quick Review (continued)
Example 1 Answer
Mikes success rate = 5/10 projects; Agnes success rate = 2/10 projects
So, if they each lend $1,000,000 10 projects @ $100,000 each
For Mike, each successful project must return $1,000,000/5 = $200,000
For Agnes, each successful project must return $1,000,000/2 =
$500,000
Mikes loan rate ($200,000 - $100,000)/$100,000 = 100%
Agness loan rate($500,000-$100,000)/$100,000 = 400%
So Agnes (being more of a risk-taker) has a loan rate that is 4 times
higher than that of Mike.
16-5
16.2 Benefits of Debt

Financial leverage is the ability that owners have
to use other peoples money at fixed rates to make
higher rates of return than would have been
possible by using all of ones own money. It
represents one of the main benefits of taking on
debt.
Firms that take on debt as part of their capital
structure are therefore known as leveraged firms
while those that do not are known as unlevered
firms.
16-6
16.2 (A) Earnings per Share as a

Measure of the Benefits of Borrowing
One way to measure the benefits of
leverage is by comparing the EPS of firms
with different capital structures under good
and bad economic conditions.
Table 16.1 presents 3 equal-sized firms, one
with no debt, one with 50% debt, and the
last one with 99.75% debt.
16-7
16.2 (A) Earnings per Share as a Measure of

the Benefits of Borrowing (continued)
Table 16.1 Capital Structure of Three Identical Firms
16-8
16.2 (A) Earnings per Share as a Measure

of the Benefits of Borrowing (continued)
Assuming a cost of debt of 10% for all firms and identical
EBIT ($2000), EPS is calculated and shown in Table 16.2.
Table 16.2 Earnings per Share of Firms with Different Funding
Structures
If the firms EBIT covers its interest cost, higher leverage

benefits the stockholders with a higher EPS.
16-9
16.2 (A) Earnings per Share as a Measure

of the Benefits of Borrowing (continued)
However, if the firms EBIT does not cover its interest cost, the
reverse is true, as shown in Table 16.3
Table 16.3 Earnings per Share of Firms with Different Funding
Structures
So leverage is a two-edged sword; benefiting firms

in good times and hurting them in bad times.
16-10
16.3 Break-Even Earnings for Different Capital

Structures
At a certain level of EBIT, known as the break-even

EBIT, all three firms will have the same EPS as
shown in Table 16.4
Table 16.4 Earnings per Share of Firms with Different
Capital Structures
16-11
16.3 Break-Even Earnings for Different

Capital Structures (continued)
To calculate the break-even EBIT we use the following method :
1) We first calculate the EPS of two firms, Company 1 and
Company 2; set them equal; ,and solve for the EBIT:
EPS = (EBIT I)/# of shares
EPS1 =( EBIT 0)/400 = (EBIT -$500)/200
400(EBIT-$500)=200(EBIT-0)
2EBIT-$1000=EBIT
EBIT =$1000
2) Next, we calculate each firms EPS at the break-even EBIT i.e.
$1000:
Company 1sEPS = 1000/400 = $2.50;
Company 2 EPS = (1000-500)/200 = $2.5
Company 3s EPS = (1000-997.5)/1= $2.5
16-12
16.3 Break-Even Earnings for Different

Capital Structures (continued)
3) Below an EBIT of $1000, e.g. $800; leverage
hurts and vice-versa as shown in Figure 16.1
Figure 16.1
Earnings per share
and earnings for
three different
capital structures.
16-13
16.4 Pecking Order
The pecking order hypothesis is based on

the notion that firms have a preferred order
of raising capital.
Accordingly, it states that:
1. Firms prefer internal financing (retained
earnings) first.
2. If external financing is required, firms will
choose to issue the safest or cheapest security
first, starting with debt financing and using
equity as a last resort.
16-14
16.4 (A) Firms Prefer Internal

Financing First
Why do firms prefer internal financing
first?
It typically requires less effort,
Avoids transactions cost,
Avoids loss of secrecy.
16-15
16.4 (B) Firms Choose to Issue Cheapest

Security First and Use Equity as a Last
Resort
Retained earnings being limited, firms have

to use other external sources such as debt
and equity.
When they do tap the capital markets, firms
tend to issue debt first, less costly, and
leads to less loss of control, and equity last,
too much debt can put the firm into a risk
of bankruptcy.
16-16
16.4 (B) Firms Choose to Issue Cheapest

Security First and Use Equity as a Last
Resort (continued)
In summary, there are three implications of the
pecking order hypothesis:
1. Profitable companies will borrow less
they have more internal funds available
and may have lower debt to equity ratios
they have more debt capacity.
2. Less profitable companies will need more external
funding and will first seek debt financing in an
asymmetric world, avoiding the equity market.
3. As a last resort, firms will sell equity to fund
investment opportunities.
16-17
16.5 Modigliani and Miller on Optimal Capital Structure
Franco Modigliani and Merton Miller (M&M), two

Nobel laureates, developed a series of
propositions around the question of whether or
not there exists an optimal capital structure that
firms can strive for.
The basic assumption underlying the various
propositions is that investment decision of a firm
is separate from its financing decision,
firms first decide which products and services to invest
in and only then figure out what mix of financing
sources they will use to finance the investment.
16-18
16.5 (A) Capital Structure in a World

of No Taxes and No Bankruptcy
In 1956, M&M introduced their first theory
which stated that in a world with no taxes
and no bankruptcy risk, a firms debt-equity
mix would be irrelevant.
M&M proposition I states that in a world with
no taxes and no bankruptcy risk, the value of a
leveraged firm (VL) would equal that of an
otherwise identical all-equity firm (VE), i.e. the
value of a firm does not depend on its capital
structure.
16-19
16.5 (A) Capital Structure in a World of No

Taxes and No Bankruptcy (continued)
Figure 16.2 Value of firms according to Modigliani
and Millers Proposition I in a world of no taxes.
16-20

M&M proposition II: states that the value of a firm depends on
three things:
1. The required rate of return on the firms assets (which is the
same for firms with identical assets or investment choices)
2. The cost of debt to the firm
3. The debt to equity ratio of the firm.
In a world with no bankruptcy risk and taxes, the value of a firm
would simply be the present value of its cash flow assumed to be
received in perpetuity,
VF = Cash Flow
r
where r is the weighted average cost of capital of the firm
(WACC) and can be calculated by using Equation 16.2.
16-21

Where E = the equity value;

D = the debt value;
V = the value of the firm = E+D
Re = the cost of equity;
Rd = the cost of debt; and
Tc = the corporate tax rate
16-22

Since V=D+E, we can manipulate equation 16.3 to solve for the cost
of equity (Re) as shown in Equation 16.4:
Ra = [(E/V)* Re] + [(D/V)Rd][(E/V* Re] = Ra - [(D/V*Rd]

Re = Ra*V/E D/E*Rd
Since V=D+E, we have
Re = Ra*(D+E)/E D/E*Rd Re = Ra*(1+D/E) D/E*Rd
Re = Ra + D/E*Ra D/E*RdRe = Ra + D/E(Ra Rd)
16-23

Figure 16.3 illustrates the trade-off between higher
levels of debt and higher cost of equity, as implied
in Equation 16.4
Figure 16.3 M&M
Proposition II.
16-24

Example 2: Applying M&Ms Propositions I and II in a
world with no taxes.
Firm A is an all-equity firm with a required return on its
assets of 9%.
Firm B is a levered firm and can borrow in the debt market
at 7%.
Both companies operate in an utopian world of no taxes and
no bankruptcy (no risk).
If M&M proposition II holds, what is the cost of equity as
firm B goes from (a) having 10% debt, to (b) 40% debt and
finally to (c) 90% debt.
Which capital structure would be the best for this levered
firm?
16-25

Example 2 Answer
To solve this problem we need to calculate the cost of
equity and the WACC, of Firm B under the 3 different
capital structures given.
With 10% debtFirm Bs debt-equity ratio is 10/90;

Ra=9%; Rd=7%; Re = 9% + (9%-7%)*1/9 9.22%
WACC = Ra = (.9*9.222%) + (.1*7%) 9%

16-26

Example 2 Answer (continued)
With 40% debtD/E = 40/60
Re = 9% + (9%-7%)*.66710.334%
WACC = .6*10.334%+.4*7% 9%
With 90% debtD/E = 90/10
Re = 9% + (9%-7%)*9 27%
WACC = .1*27% + .9*7% 9%
Since the WACC of the levered firm is the same as
that of the all-equity firm (9%) in all three
scenarios, we can say that debt does not matter.
16-27
16.5 (B) Capital Structure in a World of

Corporate Taxes and No Bankruptcy
Once M&M injected some reality into their

capital structure discussion, i.e. that taxes
are a way of life, their Propositions I and II
got turned around.
With interest being tax-deductible, the
levered firm pays less tax on its income than
an all-equity firm, and the equity holders
enjoy more in residual profits as portrayed
in Figure 16.4
16-28
16.5 (B) Capital Structure in a World of

Corporate Taxes and No Bankruptcy
(continued)
Figure 16.4 Value of
firms in a world of
corporate taxes.
As the firm issues more debt, its tax shield increases,

and the governments share of the pie decreases, increasing
the value of the equity-holders.
The new Propositions I and II are as follows:
Proposition I, with taxes: All debt financing is optimal.
Proposition II, with taxes: The WACC of the firm falls as more
debt is added.
16-29
16.5 (C) Debt and the Tax Shield
Table 16.5 EBIT

Distribution to
Claimants under
Different Funding
Structures
Table 16.5 shows the effect of increasing debt levels on the

distribution of a firms EBIT.
As the firms debt level goes from 0% to 90%, with EBIT
staying constant at $100,000, governments share of EBIT
(taxes) dwindles from $25,000 to $2,500, thereby increasing
the share of debt and equity holders from $75,000 to
$97,500
16-30

(continued)
Equation 16.5 sums up M&Ms Proposition I in a
world with corporate taxes as follows:
It shows that the value of a levered firm is greater

than the value of an unlevered firm by the amount
of the tax shield from selling debt, i.e. D*T c.
The WACC equation (with Tc>0) shows that the
cost of capital is reduced as the firm gets more
levered.
16-31

(continued)
Example 3: An all-equity firm has a value of $8 million dollars and is currently
being taxed 34% on its EBIT. The WACC for the company is currently at 16%.
The current CEO who has just learned about M&Ms capital structure theory wants
to sell $4 million worth of debt to take advantage of the tax shield on interest and
accordingly increase the value of the firm for the equity holders. Is he justified in
doing so? Please explain.
Answer
All-Equity Firm
50/50 Firm
Firm Value
$8,000,000
$8,000,000
Debt holders share
0
$4,000,000
Government share (34%) $2,720,000
$1,360,000
Equity holders share $5,280,000
$8,640,000
Yes, the equity holders wealth has increased from
$5,280,000 to $8,640,000
16-32
16.6 The Static Theory of Capital Structure
So if increasing debt levels leads to

increasing firm values, why do firms not
attempt to go for maximum debt?
bankruptcy risk.
16-33
16.6 (A) Bankruptcy

Risk of losing the firm inability of a firm to pay its debt
and other obligations. At bankruptcy, the value of equity is
equal to zero, and the value of the firms assets is equal to
or probably less than its liabilities.
Bankruptcy entails both direct and indirect costs.
Direct costs include the legal and administrative fees necessary
to settle the claims of creditors etc.
Indirect costs of bankruptcy, called financial distress costs
include lost sales, loss of valuable employees, loss of consumer
confidence, and loss of profitable opportunities while facing
bankruptcy.
The greater the amount of debt carried by a firm

greater chance of bankruptcy higher the financial
distress costs.
16-34
16.6 (B) Static Theory of Capital

Structure
Figure 16.5 M&M
Proposition II with
taxes, where VE
represents the value
of an unlevered or
100% equity-financed
firm and VL
represents the value
of the levered firm.
The optimal capital structure (i.e. D/E)* comes at the point

where the additional tax-shield benefit of adding one more
dollar of debt financing is equal to the direct and indirect cost
of bankruptcy from that extra dollar of debt.
16-35
16.6 (B) Static Theory of Capital

Structure (continued)
3 scenarios discussed in this chapter lead to the following
conclusions:
1. No taxes, no bankruptcy. Debt is irrelevant, since
the values of leveraged firms and otherwise identical
unleveraged firm are equal across all potential debtequity ratios and the cost of capital is constant.
2. Taxes, no bankruptcy. The value of a firm increases
by the amount of the tax shield due to debt. The value
of the firm is greatest with 100% debt financing and its
cost of capital is the lowest.
3. Taxes, bankruptcy. The value of a firm is maximized
and its cost of capital is minimized at the point where
the marginal benefit of financial leverage (the tax
shield) equals the marginal cost of bankruptcy
(financial distress costs).
16-36
Additional Problems with Answers

Problem 1
Different Loan Rates Diversified Holdings has
three subsidiaries, each of which borrows funds
from the parent company and has a different
success rate with the projects it undertakes.
Subsidiary
time,
Subsidiary
Subsidiary
Subsidiary
A is successful with its projects 80% of the

B gets it right 93% of the time,
C 75% of the time, and
D 85% of the time.
What loan rates should Diversified Holdings

charge each subsidiary for loans?
16-37

Problem 1 (Answer)
Subsidiary A: To breakeven with an 80% success rate the
firm will need to recoup, $1/.80= $1.25. It should charge a
return greater then ($1.25)-1 = 25%
Subsidiary B: To breakeven with a 93% success rate Sub.
B will need to recoup, $1/.93= $1.075268. He should
charge a return greater then ($1.075268/$1.00)-1 =
7.526%
Subsidiary C: To breakeven with a 75% success rate Sub.
B will need to recoup, $1/.75= $1.333. He should charge a
return greater then ($1.3333/$1.00)-1 =33.33%
Subsidiary D: To breakeven with an 85% success rate Sub.
D will need to recoup, $1/.85= $1.17647. He should charge
a return greater then ($1.17647/$1.00)-1 =17.747%.
16-38

Problem 2
Benefits of Borrowing Loyola Turbo Engines
is looking at expanding its operations by adding
another manufacturing location. If successful, the
company will make $750,000, but if it fails, the
company will lose $300,000. Loyola can borrow
the required capital of 300,000 at 16%.
(a) If all their projections point to an 85% probability of
success, should they borrow the money and go
ahead with the expansion?
(b) Above what minimum probability of success will the
project be acceptable with a discount rate of 16%?
16-39

Problem 2 (Answer)
(a) Accept when expected payout exceeds cost of loan
Exp. ret. = .85($750,000) + .15(-$300,000) = $592,500

Cost = $300,000(1+.16)
<$348,000>
Expected Profit
$244,500
(b) X%($750,000)+(1-X%)(-300,000) = 348,000
1,050,000X%=648,000 X=648000/1050000 61.71%
With a discount rate of 16%, the project would be
acceptable as long as its probability of success was
at least 61.71%.
16-40

Problem 3
Break-even EBIT: The Fast-Track Co. has thus far only
used equity to finance its operations and currently has
1,000,000 shares outstanding with an EBIT of
$1,500,000.
The newly-hired CFO firmly believes that the firm would
benefit its shareholders a great deal by issuing
$10,000,000 of debt at the rate of 10% per year and
buying back 400,000 shares.
If interest is tax-deductible, the firm is being charged a
rate of 10% interest on borrowed funds, and the firm is
in a 35% tax bracket, is the new CEO correct? Assume
that the firms operating income will remain the
same irrespective of its capital structure.
16-41

Problem 3 (Answer)
Interest on $10,000,000 of debt would be.1*$10,000,000 = $1,000,000
Indifference EBIT =[EBIT*(1-.35)]/1,000,000 = (EBIT-1,000,000) *(1-.35)
600,000
600,000*(.65EBIT)=1000000*(.65EBIT-650,000)
390,000EBIT=650,000EBIT-650000*1000000
EBIT =$1,666,666.66
So, since the firm is currently earning an operating income that is below
1,666,666.66 it would be better off not issuing debt.
Check:
.65*1,500,000/1,000,000 = $0.975 EPS (no debt)
($1,500,000-$1,000,000*.65)/600,000=$0.54167EPS (with debt)
16-42

Problem 4
M&M: With and without taxes McRonalds, which is
currently valued at $10,000,000, is looking at changing
its capital structure from an all-equity firm to a leveraged
firm with 50% debt and 50% equity. Since McRonalds is
a not-for-profit company it pays no taxes.
a) If the required rate on the assets of McRonalds is 16% (R A), what
is the current required cost of equity and what is the new
required cost of equity if the cost of debt is 11%?
b) If McRonalds loses its tax-exempt status and will be taxed at
35%, how will its value change under the new leveraged capital
structure?
Assume that its after-tax value is $10,000,000 as

an unleveraged firm.
16-43

Problem 4 (Answer)
(A) Under tax-exempt status:
RE = RA + (RA- RD) x (D/E)
Current required cost of equity:
.16 + (.16-.11) (0) = .16 or 16%

New required cost of equity:
.16 + (.16- .11) (.5/.5) = .21 or 21%
16-44

Problem 4 (Answer) (continued)
(B) If McRonalds loses its tax-exempt status:
$10,000,000 after tax value,
$10,000,000/.65= $15,384,615.38 implied before
tax value
At 50% debt amount of new bond issues =
$15,384,615.38 x (.5) = $7,692,307.70
Equity value after tax with new structure =
$7,692,307.70x (1-.35) = $5,000,000
New equity wealth after tax
= $5,000,000 + $7,692,307.7 = $12,692,307.7
16-45

Problem 4 (Answer) (continued)
Or this problem can be solved by adding the
current equity wealth unlevered to the tax
shield
VL = VE + (D x TC)
$10,000,000 + ($7,692,307.70 x .35)
$12,692,307.7
16-46

Problem 5
Equity Value in a Levered Firm Sea Crest
Corporation, which is an all-equity firm has an annual
EBIT of $2,540,000, and a WACC of 15%. The current
tax rate is 35%. Sea Crest Corp. will have the same
EBIT forever. If the company sells debt worth
$3,250,000 with a cost of debt of 10%,
What is the value of equity in the unlevered and
levered firm?
What is the value of debt in the levered firm?
What is the governments value in the unlevered
and levered firm?
16-47

Problem 5 (Answer)
Present Value of Cash Flow = (2,540,000/.15) =
$16,933,333.33
VE = $16,933,333.33(1-.35) = $11,006,666.67
VL = VE + (D x TC)
$11,006,666.67 + ($3,250,000 x .35)
= $12,144,166.67
Governments value:
Unlevered: $16,933,333.33 x .35 $5,926,666.67
Levered: ($16,933,333.33 - $3,250,000) x 0.35
$4,789,166.67
16-48
TABLE 16.6 Total Equity Wealth
16-49
Figure 16.5 M&M Proposition II with taxes, where VE

represents the value of an unlevered or 100% equity
financed firm and VL represents the value of the levered
firm.
16-50
TABLE 16.7 Financial Ratios:

Industry Averages
16-51

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Chapter 16

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16.1 Capital Markets: A Quick Review

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16.1 Capital Markets: A Quick Review (continued)

Example 1: Effect of risk on borrowing rates.

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16.1 Capital Markets: A Quick Review (continued)

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16.2 Benefits of Debt

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16.2 (A) Earnings per Share as a

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16.2 (A) Earnings per Share as a Measure of

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16.2 (A) Earnings per Share as a Measure

If the firms EBIT covers its interest cost, higher leverage

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16.2 (A) Earnings per Share as a Measure

So leverage is a two-edged sword; benefiting firms

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16.3 Break-Even Earnings for Different Capital

At a certain level of EBIT, known as the break-even

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16.3 Break-Even Earnings for Different

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16.3 Break-Even Earnings for Different

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16.4 Pecking Order

The pecking order hypothesis is based on

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16.4 (A) Firms Prefer Internal

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16.4 (B) Firms Choose to Issue Cheapest

Retained earnings being limited, firms have

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16.4 (B) Firms Choose to Issue Cheapest

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16.5 Modigliani and Miller on Optimal Capital Structure

Franco Modigliani and Merton Miller (M&M), two

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16.5 (A) Capital Structure in a World

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16.5 (A) Capital Structure in a World of No

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16.5 (A) Capital Structure in a World of No

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16.5 (A) Capital Structure in a World of No

Where E = the equity value;

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16.5 (A) Capital Structure in a World of No

Ra = [(E/V)* Re] + [(D/V)Rd][(E/V* Re] = Ra - [(D/V*Rd]

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16.5 (A) Capital Structure in a World of No

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16.5 (A) Capital Structure in a World of No

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16.5 (A) Capital Structure in a World of No

With 10% debtFirm Bs debt-equity ratio is 10/90;

WACC = Ra = (.9*9.222%) + (.1*7%) 9%

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16.5 (A) Capital Structure in a World of No

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WACC = Ra = (.99.222%) + (.17%) 9%